A cabinet committee has given an in principle approval for the sale of the government’s 51 per cent shares in HPCL — primarily a downstream company — to the upstream player ONGC, making the former a subsidiary of the latter. ONGC is expected to take over management control in HPCL with this equity sale. An immediate merger between the two entities, however, does not seem to be on the cards.
So how do we look at this development? Why the consolidation? Is vertical integration good in the oil and gas space? What does global experience say?
A global debate
Globally, there has always been a debate as to whether vertical integration across upstream and downstream activities enhances shareholder value.
When oil price is low, upstream players commit investments cautiously and have low periods of profitability, while margins of refiners could potentially expand in the short run as downstream product prices decrease less quickly than crude.
This advantage could, however, disappear in the longer run. Low oil price over longer periods of time also boost demand for downstream products. Of course, productivity differential at the refining stage, nelson complexity index of the refineries, and other factors also do play a key role in the refining margins.
The sheer size and scale of a vertically integrated oil and gas majors provide them with the ability to deal with volatility in the global crude price much better than their focused counterparts. Thus, taking an integrated position helps. The ability to adjust production to serve most profitable markets over the integrated value chain is also an advantage.
The positives
Crude oil hit the historic mark of $140 a barrel in July 2008, dropped to $43 in Feb 2009 but recovered to $100 by April 2011. But from May 2014, it has been steadily falling to hit the bottom of $37 in Jan 2016. Currently, the price is hovering at $50 a barrel.
A few years before, players like British Petroleum, Marathon, Murphy and Conoco Phillips deliberately took a call to partially wind down their refining business and stay more focused on exploration and production. Companies like ExxonMobil, however, continued to stay fully vertically integrated.
Today, with oil prices hovering at around $50 a barrel, many of the companies that remained fully integrated, including Chevron, Shell and Total, have performed better than their focused ‘pure play’ peers. So, in essence, integrated play and the resultant scale seem to be a good position to take.
The Chinese strategy
Could it also be possible that, like in China, the logic for consolidation in India is energy security? Two Chinese companies are in global top five — China National Petroleum and Petro China are in the third and fourth position, in terms of revenue. They leave behind global majors like ExxonMobil and Shell.
Largest of the Chinese oil companies are government-owned and are vertically integrated. The rationale for consolidation and vertical integration in China is a bit different.
Like India, China imports more than 70 per cent of its crude requirements and is extremely ‘crude’ hungry. Its national oil companies have been persistently acquiring oil fields and assets across the globe to secure its long term energy requirements. This they achieve by providing financial and technical assistance to oil rich countries.
For example, at least a third of power projects that came into existence in northern Africa (Eqypt, Libya, Algeria and Morocco among others) were built by China, that added more than 15 GW of power to the region.
Similar Chinese investments have flown into countries like Angola, Ghana, Sudan and Uganda. Such investments are now paying off; close to one-fourth of Chinese crude oil imports is effected through such countries. A very articulate long term energy security policy that seems to be well working!
These involve enormous investments from China and Chinese national oil companies, which represent the sovereign government for overseas oil investments. To that extent, China’s national oil companies need to be large and financially strong and have the capability to not only strike viable global deals but also be capable of managing such magnitude of imported crude.
Hence, large, fully integrated national oil companies are the best structure to secure China’s long-term energy security.
The Indian story
ONGC Videsh and Oil India Limited (OIL) have earlier ventured to acquire assets abroad. ONGC Videsh, for example, is operating in more than 15 countries. OIL has invested in oil assets in countries like Russia, Mozambique, Nigeria and Gabon. These are quite small when compared with China’s overseas energy investments, and are also quite fragmented and lack scale.
In the context of the ONGC-HPCL transaction as well as the proposed IOC-OIL news, and potentially the larger consolidation of the Indian oil and gas industry, the central idea clearly is to have large companies vertically integrated to better withstand volatility in global crude oil price on one side, and on the other, be financially strong and have the capability to acquire energy assets overseas.
More importantly, over the last decade, vertical integration strategies of Indian oil majors have been quite haphazard. Bharat Petroleum (BPCL), primarily a downstream player, has been investing in upstream assets including potential investments in Mozambique and Brazil. Same is the case with HPCL, which had set up a number of joint ventures and subsidiaries to venture into upstream business.
What's the verdict?
Upstream companies like ONGC have entered downstream business through acquisition of Mangalore Refineries and Petrochemicals (MRPL) and had planned to enter the retail business. At some point, there were also cross-holdings across ONGC, IOC and Gas Authority of India (GAIL). This lack of focus across the fragmented companies is precisely what the government is attempting to restructure. With more than 10 government-owned oil companies operating in India, consolidation could be a sensible way forward.
The ONGC-HPCL transaction may not be able to reap the full synergies of vertical integration at this point as there are no clear cut indications as to whether a merger will happen. In the short run, the two entities may still exist as is.
Again, merging the two large organisations, as and when it happens, will come with its own sets of challenges and the ability to pull the synergies through would be a challenge.
However, the immediate visible benefit is that the government is expected to make around ₹30,000 crore from this sale, as ONGC is expected to pay in cash for the share purchase.
We may not be able to see any immediate major synergies and benefits from the ONGC-HP deal per se , as it is just the shareholding that is moving from one entity (government) to the other (ONGC). But this could be a primer for a larger consolidation drive that is in the offing.